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FEDERAL RESERVE BANK OF DALLAS
September 1977

Tax ReformA Look at the Treasury's Proposals

u.s. Savings BondsProgram Becomes Net Supplier 01 Funds

This publication was digitized and made available by the Federal Reserve Bank of Dallas' Historical Library (FedHistory@dal.frb.org)

Tax Reform-

A Look at the Treasury's Proposals
By Patrick J. Lawler
Tax reform has been a perennial issue, and this year
is no exception. Moreover, prospects for a major overhaul are greater now than in some time. During his
campaign, President Carter called the current tax
system "8 national disgrace" and promised sweeping
change. At the same time, the Treasury Department,
under former Secretary William E. Simon, was finishing a study, titled Blueprints for Basic Tax
Reform, that proposes drastic tax revisions. Because
of its thoroughness and breadth, this report is a convenient starting place for considering some of the
options open to the President and Congress this year.
The Treasury presents two major alternatives. The
first features the complete integration of personal
and corporate taxes and elimination of most exclusions and deductions. The taxes would be integrated
by including corporate earnings in individual income
on a per-share basis regardless of what portion of the
profits is paid out in dividends. For individua1s, the
tax base, or net quantity subject to tax, would be further broadened by ending the current exclusions of
public transfer payments, such as social security payments and unemploymen t compensation. The 50percent capital gains exclusion would also be eliminated, but the purchase price of capital assets would
be adjusted for inflation, which would reduce the size
of the gains and turn some into losses. Other exclusions and deductions that would be eliminated
include medical expenses, charitable contributions,
state and local bond interest, and state and local
property, sales, and gasoline taxes. For businesses.
accelerated depreciation and expensing of intangible
drilling costs in the petroleum industry would be
ended. These changes would result in a simplified
tax code and, since the tax base would be larger.
lower tax rates.
The second alternative presented in the Treasury's
report is even more radical. The basic concept would
be changed from an income to a consumption tax by
subtracting aU saving from the tax base. This would
prevent double taxation of savings (once on saved
income when first earned and again on the earnings
of the savings) and totally eliminate the most complicated portions of the current tax code. There
would be no corporate income taxes nor any capital
gains taxes. For private businesses no depreciation
need be computed; an capital outlays would be immeReview I September 1977

diately deductible. Consumption would be computed
as receipts from all sources, including dividends and
loans less all savings. Savings would include net additions to savings accounts, net purchases of common
stocks, contributions to pension plans, and, for private businesses, capital goods purchases. The tax
would be progressive and the rates adjusted so that
the wealthy would not benefit at the expense of
the poor.
These proposals encompass, in their many facets,
virtually all the major issues facing this year's tax
reformers. In this article, three of the basic features
of the Treasury's proposals are evaluated on the basis
of commonly used criteria. Among the conclusions,
integration of corporate and personal income taxes
would likely improve the allocation of investment
funds, by increasing the probability that the investment activities with the highest before-tax yield
would woo have the highest after-tax yield. A second
Treasury option, adjusting the tax base for inflation,
would almost certainly improve the equity of the tax
system. On the other hand, replacing the income tax
with a consumption tax might easily cause serious
transition problems that would outweigh the potential benefits.
Criteria for evaluation
The criteria by which tax systems should be judged
are neither obvious nor universally agreed on. But at
least four are commonly used-horizontal equity,
vertical equity, efficiency, and simplicity.

Horizontal equity means simply that equals should
be treated equally. However, it is difficult to determine, in practice, which individuals are equal and
whether they are being treated equivalently. If by
"equal" is meant having the same level of well-being,
then we must concern ourselves with tastes, working
conditions, opportunities, and income (or the same
consumption if that is the tax base). Since we cannot actually measure the first three, it is easiest to
assume that tastes, working conditions, and opportunities are the same and look only at income.
But this is not always appropriate. Persons with
the same income may derive very different utility
from it. Some may be very ill and need much of their
income for medical expenses. Others may have a rela-

tively large share of leisure time. Some may like their
jobs while others do not. It is impossible to evaluate
the relative well-being of individuals without a great
deal of subjectivity. Income is only one aspect of
well-being, but at least it can be measured objectively. Thus, consideration of horizontal equity is
essentially limited to comparing the tax burdens of
individuals with equal income who may receive it
from different sources.
Evaluation on the basis of vertical equity assumes
that those who earn more are able to pay more. There
is wide agreement that the rich should pay at least as
great a percentage of their income in taxes as the
poor. Exactly how progressive the tax system should
be, however, is still a subject of controversy.
Efficiency as a major criterion of tax evaluation
concerns the generally deleterious effects of taxes on
the allocation of resources within the private sector.
Taxes not only raise revenue but also affect economic
behavior. In an effort to minimize taxes, individuals
and finns make choices they would otherwise consider less desirable. In the aggregate, there is no tax
saving since the money must be raised one way or
another, but the distorted choices remain. Typically,
taxes cause resources to be diverted from their most
productive uses. This reduces overall production and,
hence, real income.
Simplicity is actually an aspect of efficiency. A
complicated tax results in a great waste in resources
for the purpose of keeping records and filing correctly. Currently, half of all taxpayers pay someone
else to compute their taxes.
These are the primary criteria for evaluating alternative ideal tax systems. Refonn of an existing but
flawed system introduces two additional considerations. First, would a proposed change be unfair to
people who have made important decisions in the
past based on a different set of rules? Second, if
refonn is only partial, a change that appears to move
in the direction of ideal notions of equity or efficiency may actually be counterproductive in combination with remaining imperfections.
These criteria are not easy to apply. Conflicts are
unavoidable. Taxing everyone the same amount
regardless of their economic situation would be efficient, but not many would consider it equitable. And
while society might find it equitable to tax income
above a certain level at a IOO-percent rate, doing so
would be inefficient since those who had been earning
more would cut back on their effort and their output
would decline.
Furthermore, it is often difficult to detennine how
well particular criteria are met. With these difficulties
2

in mind, we examine three of the most important
Treasury proposals.
Consumption tax or income tax?
A widely accepted justification of the income tax is
that its levies are, with some impedections, directly
related to the ability to pay them. Those with high
incomes can presumably part with larger amounts
than those with low incomes without suffering more
as a result. There are, however, other ways of apportioning taxes that also have some appeal. One alternative with a long history is that those who benefit
most from Government expenditures should pay the
most taxes regardless of income. But the distribution
of benefits is often difficult to determine, as with
national defense spending, and some expenditures are
deliberately aimed at changing income distribution.
The consumption tax is based on the somewhat
different notion that it is better to tax. on the basis of
what a taxpayer withdraws from the economy (consumption of economic output) rather than what he
contributes to the economy (income from the supply
of economic inputs). Thus, income not spent is not
taxed. This results in a smaller tax base but, since
income and consumption are highly correlated, one
that is distributed among taxpayers very similarly.
Indeed, there is little to choose between consumption and income taxes on equity grounds, either horizontal or vertical. The Treasury report contends
that an income tax discriminates unfairly against
savers vis-a-vis spenders, but that conclusion is somewhat arbitrary. The report notes that with an income
tax, two taxpayers with the same lifetime resources
do not pay the same tax if their consumption patterns differ. If both have the same initial assets and
time path of labor earnings, the one who spends his
money sooner pays a smaller tax since his investment
earnings are smaller. While this "lifetime" view is
reasonable, it can be argued, with equal justice, that
two taxpayers with the same income in a particular
period should not be taxed differently in that period
since each faces the same alternatives.
With respect to vertical equity, many have argued
against a broad-based national consumption tax
because it would be regressive, but this need not be
the case. A consumption tax can be just as progressive as an income tax. While state sales taxes are levied on each purchase without regard to whether the
purchaser is rich or poor, the type of consumption tax
advocated by the Treasury proposals would be computed by the individual once a year, as the income
tax currently is. That would make it possible to tax
individuals with high consumption levels at steeply
progressive tax rates.

It is on the grounds of economic efficiency that
consumption tax proponents, including the Treasury,
make their strongest case. Switching to a consump~
tion tax would eliminate a major source of tax~caused
distortions. In allocating their after~tax income
between consumption and saving, households are cur·
rently affected by the fact that saving is less reward~
ing than it would be without the income tax. If a
household can earn, for example, 7 percent interest
on its savings and its marginal income tax rate is 20
percent, the after-tax reward for saving will be only
5.6 percent (80 percent of 7 percent) . But if the 7
percent is a good indicator of the marginal return to
capital, it means that each dollar of additional saving
could add $1.07 to next year's output. The household
that bases its decision on 5.6 percent may well save
less than it would if it were able to keep all of the
7·percent return. Thus, an optimum amount of saving may not be undertaken in the economy when
income saved is taxed the same as income consumed.

Not all saving would be exempt. A high proportion of
all saving by households, as much as 50 percent, is in
the form of direct investment in human capitaP A
large portion of private education outlays, and some
health outlays, fall in this category. Some human
capital investment-for instance, income forgone to
attend school-would not be taxed, but much of such
investment, especially tuition, would be treated like
an ordinary consumption expenditure. Thus, while
the Treasury's consumption tax would eliminate the
distortion between consumption and investment in
nonhuman capital, it would not eliminate the distortion between consumption and investment in human
capital. In addition, it would introduce a new distortion between investment in human as opposed to
nonhuman capital. Whether the net result is an
improvement would be hard to decide on the basis of
current information. S

The consumption tax would remove this distortion.
A decrease of $100 in consumption this year would
reduce taxes by $20, making it possible to increase
savings by a total of $120. At 7 percent interest it
would be worth $128.40 next year. The household
would be able to spend $107 of that amount and still
pay a 20~percent consumption tax of $21.40. The
$100 reduction in consumption yields a full 7-percent
reward with the consumption tax.

While the Treasury's consumption tax
would eliminate the distortion between
consumption and investment in nonhuman
capital, it would not eliminate the distortion between consumption and investment
in human capital.

The Treasury document argues that the elimination of the consumption-saving distortion would
induce increased savings, which would cause lower
interest rates and increased investments. This is not
necessarily true. Households that save for specific
future needs would find those needs could be met
with fewer dollars of current saving. Whether aggregate saving would increase or decrease is a question
for which economists have found different answers.1
If switching to a consumption tax turned out to have
little effect on savings, it would indicate that this
distortion flowing from the present income tax
was minimaL
However, institution of the consumption tax proposed by the Treasury could create other distortions.

I. Colin Wright, for example. has found that aggregate sav·

ing would increase in "Saving and the Rate of Interest,"
in Arnold C. Harberger and Martin J. Bailey, eels., The
Taxation of Income from Capital, Brookings Institution
Studies of Government Finance (Washington, D.C., 1969) ,
pp. 275-300. Warren E. Weber has found the opposite in
"The Effect of Interest Rates on Aggregate Consumption," American Economic R eview 60 (1970) : 591-600.
Review I September 1977

It is sometimes argued by critics of the consumption tax that such a tax would aggravate an already
existing distortion. Because a consumption tax base
would be smaller than an income tax base, the tax.
rates would have to be higher to collect the same
total tax. This, it is argued, decreases the incentive
to earn extra money. This is true for those who would
spend all of any increased earnings, but for those who
would save as much as the national average saving
rate, the tax on the extra earnings would total the
same as with an income tax. So long as saving is one
of the goals of working, work incentives should Dot
be impaired.

2. See John W. Kendrick, The Formation and Stocks of
Total Capital. National Bureau of Economic Research.
General Series, no. 100 (New York and London: Columbia University Press, 1976), pp. 90, 167.
3. It depends on the amount of nondepreciable investment
in human capital as well as the relative responaiveness of
saving to interest rate changes. compared with the extent
to which investment funds are shifted between human
and nonhuman alternatives in response to a change in
their relative rates of return.
3

The consumption tax also merits mixed ratings on
simplicity. As the Treasury study points out, this tax
would avoid many of the current complications in
our tax code. Depreciation, capital gains, corporate
taxation would all become irrelevant. Income from
capital would not have to be measured-only actual
cash receipts, which are easier to keep a record of and
are less open to varying interpretation.
On the other hand, a consumption tax has serious
weaknesses of its own. One involves the purchase of
durable consumer goods, such as houses, automobiles, and major home appliances. If the entire tax
associated with the purchase of these items is paid in
the year they are purchased, the tax will be highest
when households may be least able to afford it. Furthermore, extensive provision for tax averaging
would be necessary since a house purchase, for example, would put almost anyone into one of the highest
tax brackets.
To alleviate this problem, the Treasury develops a
complicated procedure to allow individuals to spread
out their tax payments. At their option, taxpayers
could deposit some of their savings in what the Treasury calls "nonqualified" accounts. Tax would be
paid on these deposits as though they were used for
consumption purposes. Later, money accumulated
over several years could be withdrawn, tax-free, and
used toward the purchase of a duable good. Additional funds for a durable purchase could be borrowed. Normally, proceeds from borrowing would be
taxable and repayments deductible. But money borrowed and deposited in a nonqualified account would
be ignored for tax purposes.
While these options would help to avoid the possibility of taxes exceeding income in some years, the
consumption tax has disadvantages. For one, it introduces considerable complexity since each bank
account or brokerage account would need to be classified as "qualified" or "nonqualified." This choice of
accounts would do much to maintain the importance
of planning for the purpose of minimizing tax. For
another, any capital gain on a house purchased. this
way would not be taxed, and a loss would not reduce
the tax. This violates the notion of vertical equity.
An even greater problem would be caused by the
transition from the income tax to a consumptionbased tax. An immediate switch would be unfair to
retirees who are financing current expenses by drawing down savings balances. Because they have
already paid income tax on the earnings that were
saved to create their assets, it would be unreasonable
to charge them an even heavier consumption tax on
the same money when it is spent. An alternative
would be to let spending from the principal or earn-

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ings of all currently existing assets be spent tax-free.
However, this alternative seems unreasonably generous to those living on interest and dividends since it
would eliminate their taxes forever.
The Treasury proposes to phase in the new tax
over a ten-year period, requiring the relatively welloff to compute their tax both ways and pay the
higher amount. This would clearly add to tax complexity for a fairly long period and could overwhelm
any simplifications.
The consumption tax may appeal to some on
equity grounds and might ultimately reduce taxcaused distortions and resources devoted to tax
planning and tax compliance. But the overall gain in
economic efficiency is not certain, and transition
problems are considerable.
Integration of corporate and personal income tues
If a consumption tax is adopted, there would be no
need to compute corporate income for tax purposes.
However, in the likely event that income remains the
tax base, the current tax treatment of corporate
income deserves scrutiny. The Treasury recommendation is for radical change-full integration of personal and corporate taxes. Tax payments would continue to be made by corporations, but they would be
treated as withholding for individual taxpayers. Taxpayers would treat income of corporations in which
they held shares as though it were partnership
income. Thus, corporate income would be taxable to
shareholders whether distributed as dividends or
retained by the corporation. This change offers significant benefits in equity and economic efficiency.
Perhaps the most common complaint regarding the
corporate tax is that it causes "double taxation of
dividends." Income is taxed first when earned at the
corporate level and then at the individual level when
it is paid out as dividends. Retained earnings are also
taxed twice-once when earned by corporations and
again as capital gains when shares are sold. Since
income from noncorporate equity capital and income
from labor are taxed only once, those whose income
is largely derived from corporate shares are treated
inequitably compared with taxpayers whose income
is the same amount but is derived from other
sources.t Integration would eliminate double taxation
of corporate earnings.

4. Since current shareholde rs have in most cases purchased
their shares at prices that reflected the effects of the tax,
most of the inequity was suffered by those who held
shares when the tax was ina ugurated and when it was
increased.

Another weakness of the corporate tax is its failure
to discriminate with regard to the differing income
levels of shareholders. Rich and poor alike are subject
to a 4S-percent marginal tax rate on the earnings of
their corporate shares. Integration would tax corporate income at rates appropriate to the individual
shareholders. Those in the 70-percent bracket would
pay more tax; those in the lS·percent bracket would
pay less.
The corporate income tax also causes distortions
in economic decisiomnaking, and integration would
almost certainly improve the efficiency of our econ·
omy. Because corporate income is taxed more
heavily than noncorporate income, investment spending is biased away from corporate capital in favor of
noncorporate capital. Corporate investments with a
higher pretax return are rejected in favor of other
investments with lower pretax yields. Thus, invest·
ment capital is not directed to its most productive
uses. Integration would remove this distortion.
Another distortion results because interest pay·
ments are deductible from corporate income. The
current system reduces the cost of debt financing
relative to equity financing and encourages finns to
operate with higher debt-equity ratios than they oth·
erwise would. Integration would remove this advantage of debt. Whether a net benefit results would
depend on what changes are made in capital gains
taxation. The current preferential capital gains treatment leads investors to favor stocks over bonds; integration with no change in capital gains taxation
might merely replace the debt bias with an equity
bias. The Treasury study recommends treating gains
as ordinary income, which in conjunction with integration would virtually eliminate both sources of bias.

The current preferential capital gains
treatment leads investors to favor stocks
over bonds; integration with no change
in capital gains taxation might merely
replace the debt bias with an equity bias.

A third distortion might also be purged-again
depending on possible changes in capital gains taxation. Since dividends are taxed more heavily than
capital gains, firms currently have an incentive to
minimize dividends. Integration would require
investors to pay tax on all corporate income whether
distributed or not, so this incentive would vanish. In
Review I September 1977

fact, with the current capital gains law. there would
be an incentive for firms to payout all earnings.
Retained earnings increase the value of the stock,
which creates future capital gains tax liability. So,
retained earnings would still be doubly taxed. If corporations payout all income in dividends, this double
taxation could be avoided.
To prevent this problem, the Treasury proposes
computing capital gains for equities as the difference
between the sale price and the sum of the purchase
price and all retained earnings during the holding
period. Then earnings would presumably be retained
only when the costs to firms of raising money in capital markets exceeded the improved returns, if any.
that investors might anticipate by investing their
money elsewhere. The number of conglomerate mergers would almost certainly decline.
If the capital gains law is not changed, investors
would have the incentive to demand lOO-percent payout of earnings to avoid double taxation. Firms would
then have to go to capital markets for all new financing, even though much of it might come from current investors. Significant resources would be wasted
to avoid capital gains taxes. If annual adjustments in
the purchase price to include retained earnings are
allowed, however, computing and administering the
capital gains tax would become more complicated.
The tax liability would depend not only on the sale
and purchase prices but also on the earnings of the
shares in each year the stock was held.
Another problem is caused by the treatment of
shares bought and sold in the middle of a year. How
should earnings and dividends be apportioned among
partial-year shareholders? If they are simply assigned
in proportion to the length of the holding period,
short-tenn traders would not be able to determine if
they have made a profit when they sell.
Perhaps the biggest drawback of integration is the
revenue loss it would probably cause. Revenues
would be reduced because dividend income would be
taxed only once, the size of capital gains would be
reduced. and individuals pay taxes at lower marginal
rates, on average, than corporations. The projected
loss would be smaller if pension funds and nonprofit
organizations that own a large share of corporate
stock were forced to pay tax on earnings of their
shares. The Treasury proposal would, in fact, tax
pension fund earnings, although it would exempt
employee contributions.
Regardless, some revenue will be lost. and a full
evaluation of integration requires knowledge of how
the revenue would be replaced. If it would be replaced
by an increase in income tax rates, increased distor·
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tion in choices between leisure and working hours
may result. Furthermore, since the total tax on cor·
porate income would be reduced, the value of corpo·
rate shares would rise, giving a windfall benefit to
current shareholders and a possible loss to holders of
alternative investments.
In swn, there are a number of possible problems
associated with putting full integration into practice,
but the result would be a more equitable distribution
of tax burdens, both horizontally and vertically.
Furthennore, capital would be distributed more
effectively, both between corporate and noncorpo·
rate uses and within the corporate sector, so that
investment would be chaIUleled to the areas of
greatest productivity.
Adjusting the tax base for inflation
Inflation affects the current ta.x system by distorting
the tax base and by increasing effective tax rates.
The latter results as inflation pushes individuals into
higher tax brackets. This could be avoided by adjust·
ing personal exemptions, standard deductions, and
the boundaries of the rate brackets for inflation. An
alternative solution is to cut ta.xes periodically. This
procedure has obvious political attractiveness and
has been used in recent years.
The distortions in the tax base are a more netUe-some problem. There are three major tax base distor·
tions. First, increases in asset values caused by infla·
tion are taxed as capital gains even though no real
increase in value has occurred. Second, depreciation
allowances based on historical costs understate the
loss in value of physical assets in an inflationary
period. Third, borrowers pay less tax and lenders
more as a result of the inflation premiums added to
interest rates.
Capital gains. Capital gains are currently com·
puted on the basis of actual buying and selling prices.
To the extent that the price has increased because of
general price inflation, a seller's gain is more apparent
than real. Yet the tat: is just as large. Partly on thi'i
basis, current law allows the seller to exclude from
taxable income 50 percent of the gain. This corrects
the problem and results in an accurate measure of
income only in situations where the measured gain
is caused half by inflation and half by a real gain
in value.
However, individual situations will rarely be half
and half. In other cases the current procedure is
inequitable and inefficient. It undertaxes individuals
with gains more than twice as large as those stem·
ming from inflation and overtaxes those with apparent gains that only reflect general price change.

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Taxation of all nominal capital gains discourages
investment in "growth" indusbies during periods of
rapid inflation by lowering their after-tax return.
When inflation is slower, the 5O·percent exclusion
more than compensates for inflation and provides an
incentive to invest more heavily in assets whose pros·
pective return is largely in capital gains rather than
in dividends or interest. This distortion has the effect
of channeling investment fWlds into relatively unpro·
ductive areas.
The Treasury proposes to compute gains by sub·
tracting the infiation·adjusted purchase price from
the sale price. The resulting gains would be true
income, not a mixture of income and inflation distortions, as is now the case. The 5O·percent exclusion
would be eliminated. These proposals would solve the
current problems but would complicate tax compli·
ance. The computation of capital gains on common
stocks would require adjusting the purchase price for
inflation and, if the tax integration proposals are
accepted, adjusting the retained earnings for infla·
tion for each year the stock is held. Nevertheless, at
current inflation rates, the bene6ts might well outweigh the costs.
Depreciation. Deductions for capital usage are cur·
renUy allowed on the basis of historical cost. The
resulting allowable deductions do not reflect true
usage when the historical cost on which they are
based is far below current asset costs. Taxpayers with
particularly long·lived assets are affected the most.
Accelerated depreciation is often justi6ed as an offset
to this problem, but,like the capital gains exclusion,
the rapid write·offs give excess bene6ts to some and
inadequate bene6ts to others. This is a source of
inequity in the tax structure.
The current depreciation procedures also distort
economic decisions. They encourage investment when
future inflation is expected to be slow and discourage
it when rapid inflation is anticipated. They also provide an incentive to invest in relatively short-lived
equipment since the longer the period over which the
deductions for a machine are taken, the more infia·
tion lessens their value.
The Treasury recommends that depreciation be
computed as a percentage of historical cost, as is the
current practice, but adjusted for changes in the gen·
era! purchasing power of money. To prevent over·
compensation for inflation, the Treasury recommends
simultaneously eliminating all accelerated deprecia·
tion alternatives. This improvement would also add
some complexity. The depreciation computations
would require adjusting the purchase price of each
item. But like the capital gains adjustment, it is

desirable if inflation is rapid enough. Otherwise, it
would be a lot of work with very little return.
Borrowing and lending. The Treasury reconunends
no changes in taxation of borrowers and lenders for
income tax purposes. But inflation causes a tax base
distortion for them as well. An investor in bonds is in
much the same position as an investor in stocks. Each
receives some income while holding the assets-interest to the bondholder and dividends to the stockholder. And each may sell them for a price different
than he paid for them. The Treasury would have the
stockholder pay tax on only the inflation-adjusted
capital gain but would require the bondholder to
compute his gain on a nominal basis. Adjusting for
inflation, the bondholder generally suffers a loss on
the principal, which the Treasury would not let him
deduct. Similarly, the debtor makes a gain on the
principal after deducting for inflation.
The Treasury argues that this is not inequitable to
lenders because the lender can demand and get an
interest rate high enough to offset both the inflation
and its tax consequences. For example, suppose both
borrower and lender of a one-year debt are in a
50-percent tax bracket and agree on a "real" interest
rate of 5 percent. If no inflation is expected, they set
the nominal interest rate at 5 percent. After taxes
the lender receives 2.5 percent, and the borrower
loses 2.5 percent. Now suppose each expects 5percent inflation. They can now set the nominal
interest rate at 15 percent and come out as well as
before. The lender receives 15 percent but pays 7.5
percent in taxes. In addition, his principal loses 5
percent of its value because of inflation so he nets
2.5 percent, the same as before. The borrower's position is just the reverse; he pays 15 percent but lowers
his taxes by 7.5 percent. The principal he repays
is worth 5 percent less than what he borrowed so
the net cost remains 2.5 percent. Therefore, no tax
change seems necessary.
However, different results occur when the borrower
and lender have different marginal tax rates or do
not correctly anticipate inflation. If the lender has a
50-percent tax rate and the borrower a 40-percent
rate, the lender would require a 15-percent interest
rate but the borrower would be willing to pay only
12.5 percent. In general, borrowers in low tax brackets borrow less and those in high brackets borrow
more, while the reverse is true for lenders. Funds are
not transferred from where they are most easily relinquished to where they will have the highest retumproducing another source of economic inefficiency.

agree on 5 percent interest and neither anticipates
any inflation. If a 5-percent inflation occurs, the borrower has received a windfall that is not taxed and
the debtor has incurred a loss, in real terms, that he
cannot deduct.
The solution is straightforward though. It is only
necessary to adjust the principal for inflation, tax
the resulting gain to the borrower, and let the
lender deduct the loss. Existing debts should not be
included since the interest rates were determined
Wider different tax rules. The transition would
be long since some existing debt will not mature
for another 40 years or more, but it would not be
complicated.
The change would have only minor effects on the
Federal budget. In the aggregate, the newly allowed
losses for private-sector lenders would equal the taxable gains for private borrowers. The marginal tax
rates of borrowers and lenders are probably not too
dissimilar, on average. The Treasury's own borrowing would also be affected; it would be able to borrow
at lower interest rates. But part of its saving would
be offset by lower tax receipts from Government
debtholders.
Summary and conclusions
Tax reform appears to be an important issue again
this year. The proposals in the Treasury blueprint
are among the boldest and most sweeping of those
that will receive public scrutiny. Of those changes
considered here, a switch from an income to a consumption base for computing personal taxes fares
least well as measured against the four criteria used.
Perhaps if we could start all over and design a new
tax system in a new society, a consumption tax
would be better. But the transition problems seem
overwhelming.
On the other hand, integration of corporate and
personal taxes and adjusting the tax base for inflation
have advantages great enough to warrant continued
consideration. A key problem with integration is that
it would reduce tax revenues. How those revenues
would be recouped is crucial to any tinal decision on
merging the two income taxes.
Adjusting the tax base for inflation is clearly more
desirable the higher future inflation is expected to be.
At current inflation rates, the Treasury proposals
offer clear advantages with little administrative and
compliance cost.

In addition, errors in anticipations affect the fairness of the tax. Reconsider the situation where both
Review I September 1977

7

U.S. Savings Bonds-

Program Becomes Net Supplier of Funds
By Mary G. Grandstaff
The U.S. savings bonds program has provided a
convenient and safe investment outlet for small
savers throughout its 36-year life span. Although
most people are well aware of the program as a tool
for wartime financing or as a systematic savings plan
for small savers, many may be unaware of the still
significant size of the program or its continuing
important role in financing the Federal Government.
The volume of savings bonds outatanding rose to
almost $72 billion-or more than a sixth of the privately held portion of the public debt-at the end
of 1976. Sales of the bonds increased to $7.6 billion
in 1976, while redemptions (including accrued interest) totaled $6.8 billion.
The savings bonds program originally offered
yields that were well above those available on most
alternative investments for individuals. Subsequently, the number of investment options available
to these investors, as well as the yields on the invest;.

Volume of U.S. savings bonds resumes climb
BILLION DOLLARS

60---------------------------(JUNE 30 FIGURES)

ments, has risen sharply. However, savings bonds
have two major advantages over many of the higheryielding alternative investmenta---safety of principal
and a guaranteed yield at maturity. Many owners of
savings bonds are those least able to withstand a
speculative loss. To t hese investors, savings bonds
remain a relatively attractive investment.
The wartime financing needs are long past. But
the Treasury continues to promote sales of savings
bonds as vigorously as possible because of their significant contribution to debt management.
Characteristics of program
The current U.S. savings bonds program was instituted in 1941 as an aid in financing World War II
and was designed primarily to siphon off a part of
the war-induced surge in personal income, thereby
moderating inflationary pressures. The roots can be
traced as far back, however, as the Postal Savings
Act of 1910. The program has been revised and
expanded in the postwar period, emphasizing individual savings and wider ownership of the public
debt. To achieve those goals, the savings bonds program seeks to attract small savings of a large number
of individuals through the incentives of safety,
liquidity, and convenience.
Various types of savings bonds have been offered.
Now, however, only two types-Series E and Series
H-are issued, and only $18 million of other types of
savings bonds remains outstanding.
Series E bonds, which represent almost 89 percent
of total savings bonds outstanding, are accrual
bonds-yielding income only when cashed-and may
be purchased and redeemed at most banks and thrift
institutions. Since the beginning of the program,
most purchases of these bonds have been made
through payroll savings plans in denominations as
low as $25.

'41

'46

'51

'56

'61

SOURCE: U.s. Treasury Department.

8

'66

'71

'76

Series E bonds originally yielded 2.9 percent when
held to maturity at ten years. After several upward
adjustments in response to generally rising interest
rates, these bonds now yield 6 percent when held to
maturity at five years. The owner of E bonds also has
the option of redeeming his bonds, at a lower interest
yield, anytime after the first two months following
the issue date.

For the individual saver, E bonds are similar to
regular savings accounts at financial institutions.
They represent a safe, standardized investment that
is easily and continuously available at a large nwn·
ber of sales outlets and can be readily converted to
cash without risk of loss (although early redemption
will result in a lower yield). But as is true of all fixed·
value investments, savings bonds are subject to losses
in purchasing power as a result of inflation.
Series H bonds, which account for approximately
11 percent of total savings bonds outstanding, yield
income payable semiannually. First issued in 1952,
these bonds are sold at par in various denominations
beginning at $500. Although H bonds are issued and
redeemed only by Federal Reserve banks or branches
and the Bureau of the Public Debt in Washington,
most commercial banks and other financial institutions will accept applications for H bonds and for·
ward them to the district Federal Reserve office.
Interest on Series H bonds, paid semiannually, at
present averages 6 percent for bonds held to maturity
at ten years. The owner may redeem his H bond at
par anytime after the first six months fol1owing the
issue date. The interest is 5.0 percent for the first
year, 5.8 percent for the next four years, and 6.5 per·
cent for the second five years.

been negated in recent years for individuals who
qualify to set up Individual Retirement Accounts
under the Employee Retirement Income Security
Act of 1974. Nevertheless, tax deferral of interest
on Series E bonds may still prove attractive to many
individuals-those who do not qualify for Individual
Retirement Accounts or who wish to supplement
other plans.
U.S. savings bonds possess three important fea·
tures that make them unique among Treasury secu·
rities. Savings bonds are sold directly to individuals,
the Treasury does not have close control over their
total amount, and the bonds are nonmarketable.
Savings bonds are the only U.S. Government secu·
rities that are designed primarily for individuals. A
$10,000 limit on annual purchases makes them relatively unattractive to most financial institutions, and
commercial banks continue to be prohibited from
purchasing the bonds for their own account. But
holdings of savings bonds represent more than 72 percent of the total public debt holdings of individuals.
The savings bonds debt is the only segment of the
public debt that is not under the close direct control
of the Treasury. For other Government securities,
the Treasury normally decides, in advance of issue,
the total amount to be sold. In contrast, the Trea·
sury stands ready to sell or redeem savings bonds at
the option of investors-subject only to the $10,000
limit on annual purchases of E bonds or H bonds.

U.S. savings bonds possess three important features that make them unique
among Treasury securities. Savings bonds
are sold directly to individuals, the Treasury does not have close control over their
total amount, and the bonds are nonmarketable.

Pattern of sales and redemptions
The U.S. savings bonds program reached the height
of its popularity during the war years, when funds
from the bonds accounted for about a tifth of all
funds raised for financing the war. Aided by patriotic
enthusiasm, shortages of consumer goods, and an
attractive yield (the highest rate available on any
Government security at that time), the volwne of
savings bonds outstanding rose from $4 billion at
mid-1941 to $46 billion at mid-1945.

The interest on both E and H bonds is subject to
Federal income taxes but is exempt from all state
and local income taxes. Interest on Series E bonds
is reportable for Federal income tax purposes as it
accrues, or the reporting may be deferred until the
interest has actually been received-through redemp·
tion or at final maturity. The final maturity can be
quite long. All matured E (as well as H) bonds have
been granted one or more ten-year extensions and are
earning interest at the current rate.

After the war ended, individuals began to acquire
goods that had been in short supply. Purchases of
these goods conswned a greater share of current
income, and many individuals financed such pur·
chases by redeeming their smaIl·denomination sav·
ings bonds. But sales of larger·denomination bonds
(those with face values of $200 or more) continued
to grow and combined with accrued interest on outstanding bonds to increase the total savings bonds
debt until 1950--although at a much slower pace
than in the war years.

The tax deferral feature has made E bonds par·
ticularly attractive as a savings instrument for
retirement. Some of this appeal undoubtedly has
Review I September 1977

The volume of savings bonds outstanding was
fairly stable from 1950 through 1955. After the out9

break of the Korean War in 1950 and with the
Treasury· Federal Reserve accord in 1951, yields on
competitive investments rose. and savings bonds lost
much of their attractiveness.

1963, is generally credited with being the principal
force in raising the volume of sales of smaller E
bonds-those in denominations of $25 to $200-to
almost twice the level of 1962.

Beginning in fiscal 1951, net redemptions slightly
exceeded net sales continuously. However, net
accrued interest on outstanding bonds remained suf·
ficient to keep the total savings bonds debt fairly
stable Wltil1956. That year, cash sales fell rapidly
as sales of larger·denomination bonds began to drop
dramatically, and cash redemptions rose sharply.

Of the people involved in the promotion of savings
bonds sales, some 640.000, or about 97 percent, are
volunteers. Moreover, during the IS-month period
ended September 1976, the advertising media alone
contributed about $75 million in time, services, and
space-including more than 25,000 newspaper adver·
tisements and 240,000 lines in national magazines.
Largely as a result of these efforts, the Treasury's
total public-debt servicing costs in fiscal 1976 were
nearly 2 cents less for each dollar raised through the
sale of savings bonds than for each dollar raised in
capital markets.

A major portion of the increase in redemptions
was centered in Series F, G, J , and K bonds, which
had been purchased by nonbank financial institu·
aons. These institutions were, on the whole, more
sensitive to rising interest rates on alternative invest.
ments than were individuals holding Series E bonds.
Sharply rising market interest rates resulted in
the continued erosion in the attractiveness of savings
bonds. Despite several upward adjustments in the
yield on savings bonds beginning in 1957, these
adjustments lagged the rise of market yields. The
net cash drain on the Treasury as a result of net
redemptions of savings bonds (including accrued
interest) rose to about $4.25 billion in fiscal 1960.
The volume of savings bonds outstanding rose only
slightly between 1961 and 1971, with all the increase
accounted for by accrued interest on outstanding
Series E bonds. Total redemptions exceeded total
sales in each of the 11 fiscal years.
Concern about the continued net redemptions of
savings bonds led to increased efforts to promote
sales. The yield on savings bonds was raised to 5.0
percent in mid-1969, to 5.5 percent in mid-1970, and
to 6.0 percent (the current rate) at the end of 1973.
These actions allowed savings bonds once again to
provide yields roughly comparable with those on reg·
ular savings accounts at commercial banks and savings and loan associations. The higher interest rates
and increased promotional activities have boosted
sales and ended the cash drain on the Treasury.
Except in 1974-when yields on many alternative
investments reached record levels-sales of savings
bonds have exceeded redemptions in every fiscal year
since 1971.
The major portion of sales of Series E bonds are
made through payroll savings plans. About 9.5
million individuals are currently enrolled in the payroll savings plans offered by more than 40,000 companies and state and local governments and about
3,000 Federal departments and agencies. The U.S.
Industrial Payroll Savings Committee, formed in
10

The Federal Government's debt servicing costs for
the savings bonds program include a reimbursement
fee paid to financial institutions for redeeming sav·
ings bonds. This fee averages about 12 cents for each
bond redeemed. The costs of issuing savings bonds
are absorbed by institutions and employers.

U.S. savings bonds regain role
of net supplier of funds
BILLION DOLLARS
16 - - - - - - - - - - - - - - - -

12 INFLO'W OF FUNDS

4 -

REDEMPTIONS
(INCLUDING ACCRUED INTEREST)

o
'41

'46

'51

'56
'61
'66
FISCAL YEARS

SOURCE: U.S. Treasury Department.

'71

-'76

Importance to debt management
Since its inception, the U.S. savings bonds program
has been an important instrument of debt management. The program played a key role in providing
funds for financing World War II. It also lessened
the inflationary impact of financing the war by
diverting consumer purchasing power from scarce
consumer goods to Government use in procuring
implements of war.
While attrition from the excess of redemptions
over sales was a net drain on Treasury funds from
fiscal 1951 through 1971, savings bonds redemptions
did not present the difficulties of a large volume of
debt maturing at one time. The cash drain was less
than $2 billion in most of the years, and presumably
this could have been avoided with timely adjustments
of interest rates on these bonds. In addition, the cash
drain was generally spread out during each year.

On the basis of past experience, the Treasury estimates the average life of savings
bonds purchased in 1976 at approximately
six years-or more than twice the average
for the marketable debt.
The fact that Series E savings bonds are sold at
discount with interest accruing until redemption,
rather than being paid currently, has aided in moderating the cash drain on the Treasury in the past.
In every fiscal year since 1941, annual interest accruals have exceeded payments of accrued interest on
redeemed bonds. Nevertheless, the practice of allowing interest to accrue on E bonds increases the possibilities of larger cash drains in the future. By the end
of fiscal 1976, accrued interest accounted for more
than a third of the almost $70 billion of savings
bonds outstanding. The payment of accrued interest
when bonds are redeemed will push total redemptions to higher levels and necessitate a larger volume
of sales to prevent cash drains in the future.

The longer the life of the debt, the less often the
debt must be refunded. To the extent that the Treasury is able to lengthen the maturity of the public
debt-and thus reduce the number of times it has to
enter the market each year-it eases its refunding
problems since it can be more selective in timing refiw
nancings to take advantage of more favorable market
conditions. In addition, fewer refundings by the
Treasury also contribute to a smoother flow of corporate and municipal financing in capital markets.
A very real benefit accruing from the savings
bonds program has been a reduction in the overall
cost of servicing the Federal debt. As a result of the
longer maturity and considerable donations of services and materials, it is estimated by the Treasury
that its total costs of funding the savings bonds debt
last year were approximately 25 percent less than
the average costs of funding a comparable amount of
privately held marketable public debt. The amount
of savings thus effected is significant. On average,
savings bonds accounted for about 18 percent of the
privately held public debt in 1976.
Savings bonds probably will remain an important
part of debt management as long as the Treasury
holds to the objective of directly attracting the savings of many individuals and offers rates competitive
with rates on similar alternative investments. Indicating this is its intent. the Treasury continues to
press for removal of the 6-percent rate ceiling on
savings bonds so it can react quickly to changing
financial and economic conditions and avoid the
possibility of future cash drains because of savings
bonds redemptions.

Savings bonds represent a relatively long-tenn
debt instrument. In the past decade, the average
maturity of the privately held marketable public
debt declined more than half, from about 5 to about
2 % years. Savings bonds may be redeemed, at lower
interest levels, shortly after issue but holders generally have retained their bonds for fairly lengthy
periods. On the basis of past experience, the Treasury
estimates the average life of savings bonds purchased
in 1976 at approximately six years-or more than
twice the average for the marketable debt.
Review I September 1977

11

New par banks

Texas State Bank, Abilene, Texas, a newly organized insured nonmember bank
located in the terrioory served by the Head Office of the Federal Reserve Bank of
Dallas, opened for business August 11, 1977, remitting at par. The officers are:
Oliver Howard, Chairman of the Board (Inactive); Derwood Langston, President;
James Rose, Vice President and Cashier; Hollyce McChaw, Assistant Cashier;
and Lou Dugan, Assistant Cashier.
Tanglewood Conunerce Bank, Housoon, Texas, a newly organized insured
nonmember bank located in the territory served by the Housoon Branch of the
Federal Reserve Bank of Dallas, opened for business August 15, 1977, remitting
at par. The officers are: Donald L. Neil, Chairman of the Board and Chief
Executive Officer; David H. Smith, President; and Linda K. Flournoy, Vice
President and Cashier.
Lott State Bank, Lott, Texas, an insured nonmember bank located in the territory
served by the Head Office of the Federal Reserve Bank of Dallas, began remitting
at par August 15, 1977, The officers are: Turner E. Hubby, III, Chairman of the
Board; Dixie Butcher, President; D. P. Shore, Vice President (Inactive); Kenneth
Shivers, Vice President; Betty Sudduth, Cashier; Bonnie Cooper, Assistant
Cashier; and Beatrice Arnold, Assistant Cashier.
Texline State Bank, Texline, Texas, a newly organized insured nonmember bank
located in the territory served by the Head Office of the Federal Reserve Bank
of Dallas, opened for business August 22, 1977, remitting at par. The officers
are: Rex E. Reeves, Jr., President; Ernest D. Sheets, Vice President; and
Anna Marie Osborn. Cashier.

12